The future of investing: ESG ubiquity and asset owner fee assertiveness

But there is still little agreement about the core data sets that should be used to measure ESG, let alone how they should be effectively audited.

That will change. The European Union’s adoption of an agreed taxonomy in April looks like a good starting point. This agreed definition of sustainable activities could form the centre of generally accepted metrics that investors and corporates alike are willing to work around.

Will it lead to a globally universal standard? That is unlikely.

Instead, ESG may well evolve in a similar manner to accounting standards. The need to have broadly similar standards and taxonomy is accepted across the world, but specific definitions still vary between regions (and sometimes countries).

A similar outcome is likely to take place with ESG, in which the broad concepts and ways of measuring them become universally agreed upon, but each major country or region employs idiosyncrasies when it comes to extrapolating or interpreting the data. That may mean that some regimes are initially seen as inadequate, and require updating if they are to attract non-local investor funds. 

Another likely development of ESG is that its universality leads it to become unremarkable. Much as companies declare their assets, liabilities, revenues and losses, ESG scoring is likely to become something they also express as part of the cost of doing business. And that in turn is likely to mean that ESG-specific funds fade from awareness because all funds will have to incorporate sustainability considerations.

However, it will become deeper. Intensive risk analysis of the physical impact of climate change on corporates will likely become a standard metric – and could transform the appeal of vulnerable, hard-asset based companies (such as property developers with a lot of seafront real estate).

With ESG embedding itself across the investing universe, some fund providers will likely seek to stay ahead of the game and offer ESG-plus investing; seeking to express their extraordinary fidelity to combating climate change or promoting social inclusion through particularly deep analysis of companies.

One last possibility is that ESG-related companies become the next major motors of stock market performance, much as technology stocks have propelled bourses for the past decade.

The need to combat climate change is set to remain for decades to come. Companies best seen as meeting the needs of greenifying global economies could well become investors’ new darlings – and tomorrow’s outperformers.

PERFORMANCE ANALYSIS AND FEES

Asset owners are becoming increasingly discerning over how they employ their assets. Many, including several Australian superannuation funds, feel it to be cheaper and more effective to build internal teams of investment experts, rather than pools of funds to external managers.

Plus, some larger asset owners – including Japan’s Government Pension Investment Fund (GPIF) – have started to introduce artificial intelligence-assisted quantitative analysis of their external managers, to assess their performance and how closely they hew to the mandates they are hired to represent.

More are likely to follow suit. Many state pension funds lack the resources to employ large internal teams but could potentially afford tech and data analysis solutions to better analyse their external partners. And that would, in turn, lead them to increasingly link the fees they pay to performance.

“In the traditional external mandate model, the asset owner and asset manager generally agree a flat fee, with more AUM being offered generally meaning a higher fee,” noted Janet Li, wealth business leader for Asia at investment consultancy Mercer. “But there is a lack of alignment of interest, as if there is alpha performance generated by the managers or if they have negative performance, the asset owner still pays the flat fee.”

GPIF is already doing this, essentially only agreeing to pay its external managers a passive-equivalent fee if they fail to outperform the relevant benchmark index but offering rising sums as returns increase above this level.

Some active fund managers complain that this approach fails to account for the costs of the research and investment decisions that they make, but GPIF’s essential point is simple: if you do all that and cannot outperform, why should we pay more for it?

Expect to see more of this. That in turn will likely drive more passive, or passive-plus investment approaches by fund managers for mainstream asset areas, while encouraging them to focus on more lucrative feel models in niche, inefficient or private asset areas where they can more likely turn a profit above their benchmarks.

It is also likely to maintain pressure on fund houses’ margins, meaning that the merger trend that has existed for several years now looks set to continue. Any fund manager with assets under management (AUM) of less than $1 trillion is likely to increasingly feel the heat in the coming few years.

Mercer’s Li believes it is even possible that fund managers end up charging large asset owners zero for managing the funds, or even pay them a small fee for the privilege of doing so, in exchange for receiving a healthy performance fee. Doing so, she argues, would give them asset heft and display confidence about their ability to deliver genuine performance.

“Nobody was thinking of negative interest rates 10 years back, and now they seem more likely,” noted Li. “Accessing capital may well offer intrinsic value, especially if negative interest rates become more common.”

If this seems a step too far, consider that some exchange-traded funds (ETFs) already charge zero fees. It is entirely possible to believe it happens in selective instances with institutional mandates. And if inflation fails to pick up and interest rates remain virtually zero, it could become far more likely.

The advantage of combining better partner performance analysis and more flexible fees is that asset owners are more easily able to switch between external partners.

Meanwhile, fund managers may well have to become more responsive to retain discerning clients. That would include more stringent self-analysis of their leadership capabilities and business strategy, and a willingness to adapt when these are not working.

It is also likely to mean a greater preparedness to create new products and, where needed, embark on partnerships with peers or rivals to meet client needs.